Topic 5.2 - Understanding the client and the environment in which it operates

Question 1

what is meant by the auditor understanding the entity (client) and its environment?

Answer 1

understanding of the: 
-client’s business, 
-industry and
-the wider economic and social context in which it
operates

Question 2

what are the four Steps in the Risk Assessment Process?

Answer 2

• understand entity and its environment
• identify risk
• assess risk
• respond to risk

Question 3

Once auditor understands client and its environment, which five things are they able to do?

Answer 3

■ Assess risks and identify problems
■ Determine materiality
■ Consider the appropriateness of accounting
policies and disclosures
■ Develop expectations for use when planning
analytical procedures
■ Design audit procedures

Question 4

list five things auditors do to gain an understanding of the client?

Answer 4

■ Inquiries within the entity and with external
parties (e.g. legal counsel).
■ Inspection of client’s documents and physical
assets.
■ Observation of client’s activities,
operations and premises.
■ Analytical procedures.
■ Review information from external parties.

Question 5

What are four internal source of info on the client?

Answer 5

■ Inquiries of management and others
■ Tour of the plant
■ Discussion with audit committee
■ Inspection of documents such as contracts, charts of accounts

Question 6

what are some external sources of info on the client?

Answer 6

■ Inquiries with industry associations
■ Trade journals
■ Direct knowledge of the industry
■ Reports of business analysts e.g. IBISWorld
■ Reserve Bank Reports, e.g. Statistics
and Chart Packs
■ Newspapers and other media
■ Government gazettes

Question 7

what five things make up the entity

environment?

Answer 7

• Industry, regulatory and other external factors, including the Financial reporting framework
• Nature of the entity
• Accounting policies
• Objectives and strategies and related business risks
• Measurement and review of financial performance

Question 8

what are some Industry Factors?

Answer 8

■ Are there cyclical or seasonal factors?
■ What is the level of technological
development in the industry?
■ Do particular inputs such as energy costs
play a significant role?
■ What is the nature of revenue recognition?
(E.g. high volume routine sales compared
with long term construction contracts)

Question 9

what are some Regulatory Factors?

Answer 9

■ Under what legislation is the entity regulated?
■ Any recent changes in that legislation?
■ Are there proposed changes to that legislation?
■ Is the entity impacted by government initiatives,
e.g. industry stimulation, or taxation incentives?
■ Have there been any changes to accounting
standards that impact the entity?
■ For companies operating in international
markets, what are the relevant regulations?

Question 10

what are five factors that make up the Nature of the Entity?

Answer 10

• Investments, including in special purpose entities
• Business operations and processes
• Ownership and governance
• Organisational and financial structure
• Objectives, strategies and related business risks

Question 11

what is the key concern for an auditor when considering the entity and its environment?

Answer 11

the impact on the fair statement of the financial statements.ie:

• low level of economic activity -> write downs -> higher risk of misstatements
• Client’s debt structure -> must be classified correctly->more attention to classification of debt and ratio analysis